Why Did the Peso Collapse? Implications for American Trade
Joachim Zietz, Dept. of Economics and Finance, Middle Tennessee State University

The Peso Crisis

During the late 1980s numerous countries in Latin America embarked on significant economic policy reforms aimed at making their economies more competitive internationally and raising their standards of living. Mexico was one of the first countries after Chile to undertake significant steps toward restructuring its economy. Under the Salinas administration (1988-94) the federal budget was turned from deficit to surplus, import tariffs were cut dramatically, and inflation was lowered from more than 150% in 1987 to single digits in 1994. And, above all, Mexico joined the U.S. and Canada to form the North American Free Trade Agreement in 1994.

Due to these efforts, Mexico attracted large amounts of private foreign capital. But by late 1993 this inflow ebbed, and toward the end of March, 1994 foreign exchange (dollar) reserves fell rapidly as foreign investors began pulling their funds out of Mexico because of rising political uncertainty, in particular the assassination of presidential candidate Colosio. The Salinas administration responded by devaluing the peso, which had been stabilized at around 3 pesos per dollar, to 3.4 per dollar and by raising interest rates to make the peso attractive again. Consequently foreign exchange reserves were stabilized.

On November 30, the new cabinet of the incoming president Zedillo was announced. The most significant part of this announcement was the absence of finance minister Pedro Aspe, the well-respected economic strategist of the outgoing administration, who was considered a guarantor of a stable peso/dollar exchange rate. To financial markets this change signaled that the new administration might not be as serious about maintaining the value of the peso.

Financial markets responded promptly to the political turmoil and the possibility of a peso devaluation. Foreign exchange reserves fell as investors liquidated their short-term portfolio investments and converted their pesos back into dollars. In contrast to the currency crisis of March 1994, however, the decrease in foreign exchange holdings was fully sterilized by the central bank: domestic government debt was substituted for the declining stock of foreign exchange. The objective was to avoid a decrease in the money supply, higher interest rates, and a recession. In another departure from the March crisis, the Mexican central bank virtually depleted its dollar reserves. There were only $11 billion left to draw on for currency stabilization operations rather than almost $30 billion as in March of 1994. This was much less than the $30 billion in short-term dollar-indexed government bonds (tesobonos) in the hands of jittery investors. To investors, it was clear that the central bank would be unable to support the peso at the 3.4 rate if these short-term bonds continued to be sold. Faced with the prospect of a potential peso devaluation and capital losses on their investments, many investors decided to preempt the devaluation by selling their peso assets. The rush to sell forced the Mexican government to react.

On December 20 the peso was allowed to trade without intervention to 4 pesos per dollar, up from 3.47 pesos. However this measure was perceived by financial markets as validating the fear that the new administration was not serious about keeping the value of the peso stable against the dollar. Mexican assets were quickly sold in quantity. In just one day, the Mexican central bank lost half of the remaining foreign exchange reserves (about $5 billion). Since the Mexican government was effectively out of dollar reserves, the government stopped all currency intervention and floated the peso on December 22.

During the next weeks the peso began a free fall against the dollar. The stock and bond markets tumbled; other assets also fell in price. Asset deflation had its counterpart in sharply higher interest rates which in turn increased bankruptcies among corporations and endangered the survival of banks. Faced with increasing loan defaults, deflating asset values, and large increases in dollar-denominated debt, banks effectively ceased to provide new loans. A severe credit crunch developed, forcing real economic activity to decline sharply. In order to avoid a spill-over of the Mexican crisis into the global economy, a U.S.-led rescue package providing Mexico with foreign exchange loans worth $50 billion was put into place in February of 1995. As part of this rescue plan, the Zedillo administration announced a severe austerity plan. This called for (1) a 50% increase in Mexico's value-added tax, (2) sweeping budget cuts, (3) sharp increases in electricity and gasoline prices to decrease demand and reduce government subsidies, and (4) tighter monetary policy (higher interest rates) to prop up the exchange rate. When added to the credit crunch, these measures destine Mexico for a recession.

Repercussions of the Crisis for the U.S.

The peso devaluation, which reached approximately 50%, makes U.S. goods and services more expensive to Mexico and Mexican goods and services cheaper in the U.S. The devaluation will switch Mexican demand from U.S. imports towards home goods. U.S. exports to Mexico will decline and U.S. imports from Mexico will increase. The fact that Mexico is moving into a recession will strengthen these effects.

There is little ambiguity about the direction of change of U.S. trade with Mexico in the aftermath of the peso devaluation, but the extent of U.S. export losses to Mexico may be less than the 50% peso devaluation might suggest. Although the peso did depreciate about 50% in nominal terms by March of 1995, the rate of real depreciation was more on the order of 35%. This is because prices are climbing sharply in Mexico in the wake of the devaluation. In fact, an inflation rate of 30 to 40% is expected for 1995, compared with less than 10% in 1994. If Mexican prices indeed increase by 30 to 40%, compared to a U.S. inflation rate of around four percent, the Mexican peso will depreciate by only 14 to 24% in real terms over the year. Given a medium-term price elasticity of import demand of around 0.5, this translates into a reduction in Mexican imports by only about 7 to 12% on the basis of price alone.

However to get the total response of Mexican import demand, the price effect of the devaluation needs to be added to the decline in imports induced by Mexico's recession. Mexico's gross domestic produce (GDP) is expected to decline by two to three percent in 1995. Assuming an income elasticity of import demand of two, imports from the U.S. will decrease in 1995 by four to six percent compared to 1994. Added to the price effect, U.S. exports to Mexico are likely to be 11 to 18% percent lower in 1995 than in 1994. These overall numbers hide significant variations among products and among regions in the U.S.

And in fact during the first two months of 1995 U.S. exports to Mexico have declined by 1.43 percent. This is a dramatic change when compared to an annual average increase of U.S. exports to Mexico of 16% over the last four years. A larger decline can be expected for the year as a whole. Price changes take time to be fully reflected in new contracts. And the price elasticity of import demand is relatively low in the short run. Alternative sourcing may be difficult, especially if imports from the U.S. dominate total Mexican imports, and domestic production may not be very responsive either.

Figuring the employment effect of a decrease in U.S. exports to Mexico and an increase in U.S. imports from Mexico is no easy task. The Federal Reserve has forecast a $13 to $28 billion loss in U.S. production in 1995 and job losses of 380,000 over the next four years as a direct result of the peso devaluation. Texas, which provides a third of all U.S. exports to Mexico, Arizona, and California will be affected the most, but other states - including Tennessee - will also feel the consequences.